Linear regressions, both as lines and as channels, are complex mathematical calculations and powerful trading tools that can assist the savvy forex trader toward increased profits.

As Barbara Rockefeller points out in her excellent primer, Technical Analysis for Dummies, there’s no need for forex traders to understand the calculations involved in reaching a linear regression, based on something called the “least squares” method. After all, few forex traders could give an intelligent description of the inner workings of an automatic transmission, yet most of them are probably perfectly adequate drivers. Besides, the software package is much less likely to make a mistake.

Suffice it to know that a linear regression is a line drawn through the centre of a series of price bars, rather than above or below the series as is the case with resistance or support. The linear regression line is placed so that it minimizes the distance between the extremes—the highest high and the lowest low—of the price series, coming as close as possible to each as well as to all the other prices in the series as well. Only one such placement is mathematically correct for any particular chart, and the slope of the line so determined reveals any underlying trend hidden within the market.

As an example, see the chart below. This is the current four-hour chart of NZD/USD:

At first glance, this seems to be a trendless market, with the heikin ashi price bars rolling between undefined points. A case can possibly be made for the ongoing development of a converging triangle; however, neither the support nor resistance lines can be drawn satisfactorily. The too-low central point throws off the diagram, as shown below:

However, a linear regression drawn atop even this wavering series of heikin ashi price bars shows that there is an uptrend hidden within:

Of course, within this chart there are actually at least five distinct uptrends and at least four distinct downtrends with the beginning of a fifth, and linear regression channels can and should be drawn on each of them, particularly for swing traders or scalpers. The linear regression channel for the final downtrend can be extended into the future, as a means of predicting future price action, until the downtrend is broken, a new trend begins, and a new linear regression channel can be drawn.

With linear regressions, the devil is in the details. The quality of the forecast reached is entirely dependant upon the relevance of the beginning and ending points chosen, a modern forex equivalent to the old programmer’s maxim of “Garbage in, garbage out.” Look back through the chart to find the logical beginning of the current trend, and start drawing the channel from there. For a downtrending market, this is usually the last significant highest high; for an uptrending market, it would be the last significant lowest low.

With most charting software packages, drawing a linear regression channel is simple. Select the tool from the menu list, then click on the desired beginning point, drag to the ending point, and release.

The channel about the central linear regression line is called the standard error channel; this will be discussed next week.